Stocks May Climb in These Dog Days of Summer

Stocks could continue to stair step higher, as the dog days of summer take hold and markets await central bank action in September.

The week ahead should provide insight into the consumer from earnings reports from major retailers, including Home Depot and Wal-Mart , as well as the July retail sales report. A few other important economic reports, such as industrial production and consumer and producer inflation data, punctuate a week that promises to be otherwise quiet.

Stocks, in the past week, quietly consolidated the gains made since the June 4 low. Up for eight of the last 10 weeks, the S&P 500broke through 1400 for the first time since May and then tread water around that level for four sessions. It finished the week at 1405, up 1 percent and is now up more than 9.5 percent since early June. The Dow was up 0.9 percent to 13,207, and the Nasdaq gained 1.8 percent for the week to 3020.

“This rally caught us by surprise, I have to admit. We thought the fundamentals would be weaker, and they have been, but the market does well anyway,” said Ed Keon, managing director at Prudential Financial’s Quantitative Management Associates.

Many analysts and traders have been befuddled by the stealthy summer rally, coming even as earnings reportsreveal weaker revenues and slowing earnings growth.

“The market’s certainly showing signs of fatigue,” said Art Hogan of Lazard Capital. He noted that the market internals are not great. Transports are not keeping up, volume is weak. “The interesting thing is we haven’t collapsed. We haven’t move back. I think the explanation there is expectation of aggressive monetary policy,” he said.

Stocks have also been moving higher in the face of a litany of other worries, most particularly, the European debt crisis. While the sovereign debtdrama is far from over, markets were reassured by a plan of action laid out by European Central Bankpresident Mario Draghi, even though it lacks details and requires buy in. At the same time, the Federal Reservehas promised to take action if necessary, and traders are looking to its September meeting for a possible announcement of a new bond purchase program, or quantitative easing.

“The biggest thing I’m worried about are things in Europe spinning out of control, and that might really hurt us,” said Keon. “It still keeps me from being an aggressive buyer of stock.”

But even as the central banks hold out the promise of more policy easing, worries about the economy, the U.S. elections and so-called “fiscal cliff” are containing gains, and strategists say there’s not a compelling enough case to be made for stocks either way.

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“When I look at the domestic economy, I don’t see a catalyst,” said Barclays strategist Barry Knapp, head of equity portfolio strategy. He said he continues to be positioned defensively, and he and others see potential bumps ahead. “September is the worst performing month for the market for the last 25 years,” he said.

LPL Financial chief investment strategist Jeff Kleintop notes that while September is the worst month, August is one of the most volatile and volatility could pick up before it’s over. “As we get closer to the election, around Labor Day, there’s going to be more and more focus on the fiscal cliff, more and more focus on the election,” he said. The fiscal cliff, as it's known, is the dual expiration of tax cuts Dec. 31 and the automatic, dramatic hits to federal spending and programs starting Jan. 1 if Congress does not act.

“It wouldn’t surprise me to see stocks move back to the bottom of this channel we’ve been in,” said Kleintop. Kleintop expects the market to end the year at about current levels.

On the Other Hand...

Just as they spell out the concerns, strategists still see compelling reasons to stay in the market.

Keon said there are investors who believe the prospect of Fed stimulus is creating a “sugar high,” helping to keep stocks aloft. “The other position is the market is signaling gloom and doom is overdone, and when you stand back, you’re going to get very good value,” he said.

“The election and the fiscal cliffs are all things to be nervous about but the market still moves higher despite them. You get a 2 percent dividend yield from the S&P or you can get 1.6 or 1.7 percent from the 10-year Treasury bond. That’s one of the best ratios we’ve seen in a decade, plus with stocks you get some long term protection against inflation,” he said.

Kleintop said one measure he follows, the Citigroup G-10 economic surprise index, is starting to show a turn. The indicator, including a separate one for the U.S., has been turning higher. It is based on the difference between economists’ forecasts and actual economic data. Economists, for now, have become so gloomy in some cases that their view is worse than the actual data.

One example was the better-than-expected July jobs report, which showed 163,000 nonfarm payrolls compared to economists’ 100,000 consensus forecast. Plus, there’s been improvement in weekly jobless claims for the last two weeks, though it is too soon to declare a stabilization in the data.

“It tells me expectations have gotten so low. What I find is the market tends to track that,” he said. “...We’re seeing the expectations index rise. This starting to turn supports what stocks have done in the last few weeks. There’s still kind of a big gap. Stocks are still kind of ahead of where the economic data is relative to expectations. The economic data has to play catch up, if these gains are going to be sustained.”

Keon also pointed to an improvement in data, but he specifically pointed to the improvement in housing, which has been a major drag on the economy for years. Plus the consumer has been successfully deleveraging. “It’s still too early to break out the champagne, but it looks to me like maybe the fourth quarter might be a little bit better than expectations.”

“The market always climbs a wall of worry, and this is a perfect example of it,” he said.

What to Watch in the Week Ahead:

Monday

Earnings: GroupOn, Sysco, Iam Gold

Tuesday

Earnings: Home Depot, TJX, Michael Kors, JDS Uniphase, Flowers Food

0730 am NFIB survey

0830 am Retail sales

0830 am PPI

1000 am Business inventories

Wednesday

Earnings: Deere, Target, Cisco, Applied Materials

0700 am Mortgage applications

0830 am CPI

0830 am Empire state survey

0900 am Treasury international capital flows

0915 am Industrial production

1000 am NAHB survey

0800 pm Minneapolis Fed President Narayana Kocherlakota on Federal Reserve and role of its board

Thursday

Earnings: Wal-Mart, Dollar Tree, Aeropostale, Gap

0830 am Initial claims

0830 am Housing starts

1000 am Philadelphia Fed survey

0800 pm Minneapolis Fed’s Kocherlakota on Federal Reserve and role of its directors